Stabilization Policy: A Reconsideration

By Yellen, Janet L.; Akerlof, George A. | Economic Inquiry, January 2006 | Go to article overview

Stabilization Policy: A Reconsideration


Yellen, Janet L., Akerlof, George A., Economic Inquiry


I. INTRODUCTION

In 1936 Keynes's General Theory explained how fiscal and monetary policy could be used to end depressions. Since that time no developed country has ever seen a downturn on the scale of the 1930s. The General Theory was not just a how-to book on the avoidance of depressions. It was an argument for stabilization policy itself.

The years since The General Theory have seen a revolt against Keynesian economics. In a revisionist mode, Milton Friedman argued that countercyclical policy cannot affect the average level of unemployment and output. Robert Lucas and Thomas Sargent (1979) went further, contending that it is not only impossible to increase average output, it is also impossible to stabilize it. More recently, Lucas (1987, 2003) has argued that policies to stabilize output, even if effective, would yield negligible welfare gains. Thus, stabilization policy should not be a macroeconomic priority.

Lucas's conclusion notwithstanding, stabilization policy has long been an explicit or implicit objective of monetary policy in most industrial countries, even including those countries with inflation targets. The volatility of output has, in fact, declined in most major industrial countries since the mid-1980s, and monetary policy arguably deserves at least partial credit (see Bernanke 2004). Mirroring practice, monetary policy research commonly takes it as "given" that, along with price stability, stabilization policy--the minimization of squared deviations of output around potential--is an appropriate policy objective (see, for example, Clarida et al. 1999). In this article we explore the economic rationale for stabilization as a policy goal, concluding that it does, in fact, deserve high policy priority. We survey a large body of literature that critiques the validity of key assumptions in Lucas's argument. We also offer suggestive evidence that stabilization policy can significantly reduce average levels of unemployment by providing stimulus to demand in circumstances where unemployment is high but underutilization of labor and capital does little to lower inflation. A monetary policy that vigorously fights high unemployment should, however, also be complemented by a policy that equally vigorously fights inflation when it rises above a modest target level. The Federal Reserve Act thus wisely enunciated price stability and maximum employment as twin goals for monetary policy.

II. THE CASE AGAINST STABILIZATION POLICY

Macroeconomic analysis typically assumes that social welfare depends negatively on both inflation (above a modest target level, here assumed zero) and unemployment (above some minimum, socially efficient level). For example, a standard social welfare function is the discounted sum of period losses ([L.sub.t]) of the form (see, among others, Barro and Gordon 1983, pp. 592-93):

(1) [L.sub.t] = a([u.sub.t] - [1 - k][u.sup.*])2 + b[[pi].sup.2.sub.t],

where [u.sub.t], and [[pi].sub.t] are the unemployment and inflation rates in period t, and [u.sup.*] is the natural rate of unemployment. The coefficient k is positive, reflecting the desirability of unemployment below the natural rate. Because real economies deviate in many respects from perfect competition, the natural rate of unemployment is likely to exceed the socially optimal unemployment rate. For example, with monopolistic competition, goods are underproduced because they are priced above marginal cost, so "potential output" is inefficiently low and "equilibrium unemployment" is too high.

Standard macroeconomic analysis additionally assumes that inflation is determined by an expectations-augmented, accelerationist Phillips curve of the form

(2) [[pi].sub.t] = [[pi].sup.e.sub.t] - f([u.sub.t] - [u.sup.*]) + [[epsilon].sub.t],

where [[pi].sup.e.sub.t] is the expected inflation rate at time t (with expectations formed at t - 1), and [[epsilon].sub.t], captures supply shocks to the Phillips curve at t. …

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